How should the Fed's quantitative easing program affect my investment decisions?

As widely expected the Federal Open Market Committee (FOMC) today announced its plans for a second round of quantitative easing, affectionately dubbed QE2 by market participants. The Fed stated that it will purchase an additional $600 billion of Treasury securities "in order to promote a stronger pace of economic recovery."

So, what does this mean for investors? Should we be buying stocks? Bonds? Gold bullion? Stuffing money into our mattresses and stocking up on canned food and ammunition? Well, before we jump to any rash conclusions let's take a step back and answer a few questions that may shed some light on the significance of today's Fed decision.

Um, just exactly what is quantitative easing?

Well, I'm glad you asked. You're already a step ahead of the vast majority of the investing public, which tends to rush to important investment conclusions with what I'll judiciously call a less-than-complete grasp of the basics. Simply put, quantitative easing (QE) involves the central bank of a country creating new money to purchase assets. QE is often used synonymously with "printing money" although in reality the Fed creates new money electronically, effectively increasing the balance in its account. And to answer your next question, “No.”, you and I cannot embark on quantitative easing programs of our own in order to increase the balances in our personal accounts; that privilege resides solely with the Fed.

Why is the Fed doing this?

The short answer, as provided by the Fed itself, is, "in order to promote a stronger pace of economic recovery." Doesn't really tell us a whole lot, does it? So what is really going on?

You probably don't need me to tell you that since the latest financial bubble popped in 2008 and the global economy nearly went apocalyptic, things haven't gotten a whole lot better for those of us unfortunate enough not to work for a corporation that was able to turn taxpayer-financed government bailout money into six-, seven-, or eight-figure bonuses for its employees. Well, the Fed has noticed this too and is trying to make amends. Under normal circumstances, the primary weapon in the Fed's arsenal is the Federal funds rate, the short-term rate at which the Fed lends money to banks and as such helps to set the rates at which banks lend to customers. The math on this one is pretty simple; if economic activity is sluggish and unemployment is high -ring any bells? -then the Fed will lower the Fed funds rate in order to encourage borrowing, spending, and investment, thereby stimulating the economy and reducing unemployment. Unfortunately for the Fed, it already lowered this rate to nearly zero two years ago and the world just isn't ready for the concept of negative interest rates. That leaves quantitative easing as the least-bad option available to the Fed in order to attempt to stimulate the economy. The plan is for the Fed is to spend its newly created wealth to purchase government bonds in order to drive longer-term interest rates lower and jump-start economic activity.

Will it work?

I guess we should dub that one the $600 billion question. Or more accurately, if we count the $1.7 trillion QE1 program, the $2.3 trillion question. A few more rounds of this and you're starting to talk about real money.

The reality is that no one really knows how this will play out. If the Fed gets its way, the additional securities purchases will have the following effects: interest rates go lower, saving becomes less attractive due to the lower rates, borrowing becomes more attractive for the same reason, spending money rather than saving it seems like a good idea so consumers and corporations alike borrow and spend, increasing the profits of the banks they borrow from and the corporations whose products they purchase. The net result of all this is that corporate profits get healthier and corporations now feel confident enough to hire new employees, driving down the stubbornly high unemployment rate. Easy enough, right? That brings us to the nest question.

What could go wrong?

Quite a few things actually. Although the Fed is unique in its ability to create money, it can, just like the rest of us, lose money on its investments. Imagine the price of government bonds declines ten percent, not too difficult to imagine given today’s reaction of the long bond (down 2%) to the quantitative easing announcement. Now the Fed is sitting on a loss of $60 billion and interest rates are higher than when it began its attempt to lower them. Then what do you do if you’re the Fed? Pretty tough to make the case that more QE is going to help.

Even if the Fed is successful in driving down interest rates it runs the risk of creating runaway inflation along with new and bigger asset bubbles. I’ll try to keep this one simple:

•The Fed increases the supply of money via quantitative easing

•It is successful in driving down interest rates through the purchase of government bonds

•Investors look to other asset classes because the returns on government bonds have been driven so low by the Fed’s purchases

•Investors irrationally bid up the price of other asset classes in the belief that prices can only go higher

•It all ends in tears

If this all sounds familiar, it should.

One final potential fly in the Fed’s ointment: at some point it, along with the U.S. government, may lose credibility with global investors. If all this talk of the central bank creating money to purchase the debt obligations that the federal government continues to stockpile sounds fishy to you, you are not alone. Imagine you are the Chinese government, holding trillions of dollars worth of U.S. debt; at what point are you going to say, “Enough is enough.” and start looking for someone else to lend money to? And if the world loses faith in the ability of the U.S. government to pay off its debts? Well, then you just might start thinking about the aforementioned stockpiling of food and ammo. Granted, I severely doubt that it will come to anything resembling this but this is the kind of worst-case scenario making the rounds of the doom-obsessed.

So what’s a humble investor like me supposed to do about all this?

First off, don’t panic. Don’t sell all of whatever you own now and buy something else because the incessant chatter of certain unnamed CNBC hosts makes it seem like that is an investment strategy. I recommend spreading your investments over a number of different asset classes: domestic and international stocks (they will perform well if the Fed is successful), government bonds (they’ll do well if inflation and economic activity continue to remain muted) and inflation-protected bonds, which will reward you if the Fed does indeed create higher inflation. As always, I think the best way to gain exposure to these asset classes is through the purchase of low-cost index funds or ETFs. And if you’ve got some money that you absolutely can’t afford to lose in the short term, e.g. the down payment for a house you’re in contract on, by all means keep that money in cash despite the paltry rates on offer.